Advanced Articles Satellite

November 2009

SuperUser Account — Sun, 01 Nov 2009 08:00:00 GMT

FASB Statement No. 157: Fair Value Measurements

Contents

Transition Guidance
Definition of Fair Value
Exit Price Concept
Market Based Measurement
Fair Value

Issues Related to
Liabilities
Disclosures
Internal Control Considerations

To our clients and other friends:

Since its issuance FAS 157 has been the subject of significant controversy. Amid the current worldwide financial crisis, the backlash against the fair-value accounting standard has even found its way into the $700 billion bank bailout bill recently signed by President Bush. Provisions of the bill instruct the Securities and Exchange Commission (SEC) to study current accounting literature including mark-to-market rules and if necessary suspend the application of FAS 157. Although it is impossible to know what actions, if any, the SEC might take, we believe it is a good time to revisit the substance of FAS 157 including the updates to this literature recently provided by the regulators and standard setters. We hope this publication will be useful in understanding the basic provisions of FAS 157. MHM professionals would be pleased to assist you in your understanding and are just a phone call away.

On September 30, 2008, the SEC Office of the Chief Accountant and the FASB Staff issued a joint communication to provide further clarification on fair value accounting. The communication was necessitated by the current economic environment and is intended to help preparers, auditors, and investors address fair value measurement questions that have been identified as most urgent in the current environment. The communication can be found at www.sec.gov/news/press/2008/2008-234.htm.

On October 10, 2008, the FASB issued FASB Staff Position No. FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active, which largely parallels the aforementioned communication. FSP FAS 157-3 clarifies the application of FAS 157, in a market that is not active and provides an example to illustrate certain key considerations in the determination of fair value of a financial asset when the market for that asset is not active.

Issues related to the application of FAS 157 addressed by FAS 157-3 include the following:

1) How the reporting entity's own assumptions (that is, expected cash flows and appropriately risk-adjusted discount rates) should be considered when measuring fair value when relevant observable inputs do not exist.

2 ) How available observable inputs in a market that is not active should be considered when measuring fair value.

3) How the use of market quotes (for example, broker quotes or pricing services for the same or similar financial assets) should be considered when assessing the relevance of observable and unobservable inputs available to measure fair value.

The FSP reiterates previous guidance provided by paragraph 7 of FAS 157 that in situations in which there is little, if any, market activity at the measurement date, the fair value measurement objective remains the same, i.e. fair value is based on an orderly transaction that is neither a forced transaction nor a distressed sale. Even in times of market dislocation, preparers are cautioned that it is not appropriate to conclude that all market activity is representative of either a forced liquidation or distressed sale. However, (and this is a key point of emphasis of FSP FAS 157-3) it is also not appropriate to automatically conclude that any transaction price is determinative of fair value. The determination of fair value is dependent on the facts and circumstances present and will require the use of professional judgment to determine whether individual transactions represent a forced liquidation or distressed sale.

FSP FAS 157-3 also clarifies that when relevant observable inputs are not available, the reporting entity may use its own assumptions (based on what it believes market participants would use) when pricing an asset in a current sales transaction. In some cases observable inputs may exist, however, they might require adjustment based on unobservable data (rendering a Level 3 fair value measurement). Situations where the volume and level of trading in an asset have significantly declined or where prices are not current are examples of circumstances where adjustment to observable inputs might be required. Additionally, FAS 157 discusses a range of information and valuation techniques that can be used when observable inputs are not available. However, an entity must always include appropriate risk adjustments that market participants would make for both nonperformance and liquidity risks.

Broker (or pricing service) quotes may be an appropriate input when measuring fair value. However, such quotes are not necessarily determinative if an active market does not exist for the financial asset. In an active market, a broker quote should reflect market information from actual transactions. Conversely, when markets are not active, brokers may rely on models using unobservable inputs known only to the broker. Therefore, entities need to exercise judgment on the amount of reliance they place on quotes that do not reflect the result of market transactions (presumably less reliance). Additionally, the nature of the quote (either an indicative price or binding offer to transact) should also be considered when evaluating the available evidence.

The application of the guidance provided by the FSP FAS 157-3 is accounted for as a change in accounting estimate pursuant to FASB Statement No. 154, Accounting Changes and Error Corrections. However, the disclosure provisions of Statement 154 for a change in accounting estimate are not required for revisions resulting from a change in valuation technique or its application.

FAS 157: Fair Value Measurements, was issued by the Financial Accounting Standards Board in September 2006. It provides clarification of the definition and premise of "fair value" when another standard requires or permits the use of a fair value measurement. FAS 157 also attempts to simplify the application of generally accepted accounting principles by using the same principle for fair value when a fair value measurement is required or permitted.

FAS 157 does not provide or require any new fair value measurements. However, given the significant number of fair value measurements throughout generally accepted accounting principles, the impact of FAS 157 is likely to be significant and far reaching.

Transition Guidance

Companies are required to adopt Statement No. 157 for financial statements issued for fiscal years beginning after November 15, 2007 (2008 for calendar year-end companies).

FAS 157 is generally to be applied prospectively as of the first interim period for the fiscal year in which it is initially adopted. Early application is encouraged. However, FAS 157 identifies three items which require a limited form of retrospective application:

1) The use of blockage factors.

2) Financial Instruments that were measured at fair value using the transaction price (pursuant to EITF 02-3).

3) Valuation of a hybrid financial instrument that was measured at fair value using the transaction price (pursuant to FAS 155).

The transition adjustment is measured as the difference between the carrying amounts and the fair value of the assets and liabilities at the date of adoption and is recognized as a cumulative-effect adjustment to the opening balance of retained earnings.

However, the FASB has issued FSP 157-2 which defers the effective date of FAS 157 for one year for nonfinancial assets and liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually).

FAS 157 is applicable when assets and liabilities are required to be measured at fair value for either recognition or disclosure purposes pursuant to existing generally accepted accounting principles with certain exceptions. The exceptions to FAS 157 are as follows:

. Existing standards that address share-based payments, including FAS 123R, FAS 123 and APB Opinion No. 25 (and related interpretations).

. Revenue recognition for transactions that require the use of vendor specific objective evidence (VSOE).

. Accounting Research Bulletin No. 43, Restatement and Revision of Accounting Research Bulletins, Chapter 4, "Inventory Pricing."

. Loss contingencies under FAS 5.

. FAS 13 and its related interpretations.

FAS 157 does not eliminate the practicability exceptions to fair value measurements in accounting pronouncements within the scope of this statement.

�

Definition of "Fair Value"

FAS 157 provides the following definition of "fair value": The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

FAS 157 presumes an "orderly transaction" that is - assets and liabilities are exposed to the market for usual and customary marketing activities. A fair value measurement is not the result of a transaction that is either a forced sale, liquidation or a distress sale.

Exit Price Concept

FAS 157 clarifies that the basis for a fair value measurement is the price that a company would sell or dispose of its assets or transfer a liability. This is an "exit price" concept and differs significantly from pre FAS 157 practice which relied more on an "entry price" concept.

An exit price concept is based on the company's current expectations about future cash inflows or outflows from the perspective of a market participant.

The exit price concept applies regardless of the company's actual intent and/or ability to sell the asset or transfer the liability at the measurement date. It is a hypothetical transaction at the measurement date.

�

Definition of a Market Participant

A market participant is a buyer or seller in the principal (or most advantageous) market for the asset or liability that is:

. Independent of the reporting entity; that is, they are not related parties, as defined by FAS 157.

. Knowledgeable; having a reasonable understanding about the assets or liabilities and the transaction is based on all available information that might be obtained through due diligence efforts that are usual and customary.

. Able to transact for the asset or liability.

. Willing to transact for the asset or liability; that is, they are motivated but not forced or otherwise compelled to do so.

�

Principal (or Most Advantageous) Market

A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for that asset or liability or, in the absence of a principal market, the most� advantageous market for the asset or liability.

�

Market Based Measurement

FAS 157 emphasizes that fair value is a market-based measurement, not an entity-specific measure. However, market participants should not consider the synergies that impact the value to a strategic buyer. Accordingly, a fair value measurement is determined based on the assumptions that market participants would use in pricing the asset or liability.

Determining the assumptions of a market participant is very subjective and will require the use of a significant amount of judgment. Market participant assumptions are incorporated in fair value measurements through the inputs to valuation techniques.

Definitions:

The principal market is the market in which the company would sell the asset or transfer the liability with

the greatest volume and level of activity for the asset or liability. The most advantageous market is the market in which the company would sell the asset or transfer the liability with the price that maximizes the amount that would be received for the asset or minimizes the amount that would be paid to transfer the liability, considering transaction costs in the respective market(s).

As a basis for considering market participant assumptions in fair value measurements, FAS 157 establishes a fair value hierarchy that distinguishes between the following:

. Market participant assumptions developed based on market data obtained from sources independent of the Company (observable inputs).

. The Company's own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs).

The FAS 157 fair value hierarchy prioritizes observable market data and input in valuation approaches as compared to company derived data that is based on unobservable inputs. Therefore, fair value measurement should maximize the use of observable inputs and minimize the use of unobservable inputs to valuation techniques. The fair value hierarchy also significantly impacts the disclosures related to fair value.

Level 1 - unadjusted quoted prices in active markets for identical items.

Level 2 - observable inputs (prices for similar items, rates, etc.) for the item, including market corroborated inputs, that might need adjustment.

Level 3 - entity's own assumptions about the assumptions a market participant would use, developed based on best information available without incurring undue cost and effort.

�

Fair Value Measurement

A fair value measurement should consider attributes specific to the asset or liability. For example, an asset or liability might be considered "standalone" (as in the case of a financial instrument or operating asset) or as a group of assets and/or liabilities (for example, an asset group, reporting unit or business).

Unit of Account

Whether an asset or liability is standalone or part of a group is dependent on its unit of account. The unit of account determines what is being measured by reference to the level of aggregation or disaggregation. The unit of account is determined in accordance with the provisions of other applicable accounting standards.

�

Fair Value Premise

FAS 157 presumes that fair value of an asset is based on the highest and best use of the asset based on the perspective of the market participant which will maximize the future cash inflows related to the asset. The company's intended use may not be indicative of the highest and best use of the asset from the view of the market participant.

When an asset provides maximum value to a market participant primarily when used with other assets as a group, for example an operating asset used in combination with other assets of the company, its highest and best use is considered "in-use." However, even if the "in-use" premise is applicable, the fair value measure is still based on the use of the asset by a market participant.

If an asset provides maximum value to a market participant on a stand-alone basis, for example, a financial asset, its highest and best use is considered "in-exchange."

To illustrate the fair value premise, consider the following:

A company purchases property and intends to operate it as a drive-in movie theater, while a market participant would consider the highest and best use of the property as a parking lot. In this case, the property's fair value is based on its market participant determined highest and best use, as a parking lot.

Issues related to Liabilities

A fair value measurement of a liability assumes that the liability is transferred to a market participant at the measurement date and that the risk related to nonperformance is unchanged before and after the transfer.

Nonperformance risk is the risk that the obligation will not be fulfilled and it affects the fair value of the liability that is transferred. Therefore, a fair value measurement for a liability must reflect the consideration of the risk of nonperformance. Nonperformance risk includes, but may not be limited to, the company's own credit risk. For liabilities that are required to be remeasured at fair value, the company should reflect the changes in the company's credit standing. Companies should also consider the terms of any collateral and/or other credit enhancements contractually specified for the liability being measured or remeasured.

Many observers have commented on the requirement for a company to consider its own credit standing; noting that the requirement could lead to counter-intuitiv� results. For example: a poorly performing company that experiences a deterioration in the quality of its credit might record a "gain" based on the concept that its liability is now worth less.

�

Other Issues

Use of Investment Blocks

Prior to the issuance of FAS 157, the historical practice for measuring the fair value of large holdings of securities ("block") often included the use of a blockage factor. A blockage factor is a discount to the price of the security to reflect the lack of trading volume in the market. Because the market is unable to absorb the block without impacting the price of the security, the use of a blockage factor was deemed necessary.

FAS 157 does NO T allow the use of a blockage factor. The fair value of securities is simply the price multiplied by the quantity of securities.

�

Restricted Securities

In some cases a company may hold securities of an issuer for which sale is legally restricted for a specified period. Assuming the restriction is transferable to a market participant, the fair value of the securities should be adjusted to reflect what market participants would demand because of the risk relating to the inability to sell the security for the specified period of restriction.

FAS 157 does not exempt securities that are restricted for one year or less. Accordingly, FAS 157 has amended the prior requirement provided by FAS 115, Accounting for Certain Investments in Debt and Equity Securities, for measuring fair value of securities for which sale is restricted for a period less than one year.

Transaction Costs and Transportation Costs

Transaction costs represent the incremental direct cost to sell an asset or transfer a liability (for example, a commission or fee typically charged by a broker in a securities transaction). Because such costs are not considered an attribute of the asset or liability, the price in the principal (or most advantageous) market is not adjusted for the incurrence of transaction costs.

However, transaction costs do not include the cost incurred to transport the asset or liability to/from its principal (or most advantageous) market. Accordingly, the price in the principal (or most advantageous) market is adjusted for the costs incurred to transport the asset or liability to/from its principal (or most advantageous) market.

�

Disclosures

The disclosure requirements in FAS 157 are primarily focused on three main objectives:

. Disclosure of the specific assets and liabilities that are measured at fair value.

. The methods and assumptions that a reporting entity uses to measure fair value.

. The impact that the use of fair value measurement has on earnings.

The disclosure requirements under FAS 157 vary depending on whether the asset or liability is measured on a recurring or non-recurring basis.

For assets and liabilities measured on a nonrecurring basis disclosure should include the fair value measures recorded in the period and the reasons for such measures. If Level 3 inputs are used to measure assets or liabilities, a description of the inputs and the information used by management to develop the inputs must be disclosed.

Assets and liabilities that are measured at fair value on a recurring basis require quantitative disclosures regarding fair value measures for each major category of assets and liabilities. These disclosures should include the fair value measure at the reporting date in total and also by each level of the fair value hierarchy (Level 1, Level 2 or Level 3). Level 3 inputs require a reconciliation of the beginning and ending balances including gains and losses (realized and unrealized). Companies should also disclose the valuation technique used in their fair value measurements and any changes to the techniques used.

In response to concern from observers about the reliability of fair value measures using Level 3 inputs, the FASB has required detailed disclosure related to the use of such measurements aimed at providing financial statement users with information to assess the quality of reported earnings.

�

Internal Control Considerations

As with the adoption of any new accounting standard, FAS 157 will likely require adjustments to a company's system of internal control.

. Risk assessment to determine whether the adoption of FAS 157 represents an increase in risk to accurate and reliable financial reporting.

. Revision to policy and/or procedures in order to comply with FAS 157 and the communication of such policies and procedures.

. Documentation surrounding new or revised policies and procedures.

. Consideration and documentation of new or revised assumptions particularly those pertaining to Level 2 and Level 3 inputs.

�

The Substance of the Standard is a publication of the Professional Standards Group of Mayer Hoffman McCann P. C.

The information presented herein is not intended to provide comprehensive guidance on valuation techniques or theory, the complexity of which is well beyond the scope of this publication. Additionally, the publication does not intend nor does it cover all possible issues that might arise with respect to the application of FAS 157. Companies should refer to the texts of the applicable accounting standards and recognize that as modifications or interpretations to existing standards emerge, this publication may become obsolete. This publication is designed to provide accurate information in regard to the subject matter covered. It is provided with the understanding that it does not constitute legal, accounting or other professional advice. If such assistance is required, the services of a competent professional person should be sought.

�

January 2009

SuperUser Account — Thu, 01 Jan 2009 16:00:00 GMT

The Substance of the Standard

Private Company Valuation Issues:Guidance for Determining the Fair Value of Common Stock for Purposes of Determining Stock- Based Compensation under FAS 123R

�

Contents

Overview
Issues
Valuation Hierarchy of Consideration
Use of Independent Valuation Report
AICPA Practice Aid
Management Analysis
Timing of Option Grants
Independence
Appendix

�

Overview

The FASB's issuance of Statement No. 123R, Share-Based Payment, has highlighted the need for increased focus on the determination of fair value attributed to the common stock of private companies. This increased focus stems largely from the following:

. Prior to the issuance of FAS 123R the accounting for share-based payment awards was typically reflected in a pro-forma presentation in the notes to the financial statements. Under FAS 123R, the fair value of share-based awards is reflected in earnings.

. The fair value of common stock is an integral assumption used in the option pricing model selected by management to determine the fair value of its sharebased awards which are ultimately expensed pursuant to FAS 123R.

�

Purpose

The purpose of this publication is to assist both management and auditors in the determination of the fair value of private company common stock for use in determining stock-based compensation under FAS 123R. The presentation is intended to provide practical guidance on the type of issues often encountered when valuing private company securities.

�

Issues with Private Company Common Stock Valuation

. A market does not typically exist for the common stock of a private company.

. There are usually few (if any) common stock transactions.

. Common stock transactions when they do exist are often consummated with related parties.

. Capital formation is typically accomplished by private companies with securities that contain preferences over and above the entity's common shares (preferred stock).

. Third party valuations are usually not available.

. Management may be unable to effectively document their consideration of facts and circumstances surrounding the value they ultimately attribute to their common stock.

�

Valuation Hierarchy of Consideration

(1) Readily Determinable Market Value

. To the extent a market exists for the common stock of a private company it should be used to value the common stock.

. This is likely to be a rare occurrence. However, some examples of this might include a private company that trades on the "pink sheets" or a company that is employee owned thereby creating a market mechanism for its common stock.

. Keep in mind that although a market mechanism may exist, it should be evaluated to determine whether it is truly suitable for use in determining fair value. For example, a market may exist yet not produce enough measurement points to provide a reliable measure of the fair value of a company's common stock.

(2) Independent Third Party Valuation

. Absent a readily determinable market value, an independently performed third party valuation of a company's common stock can provide excellent evidence of fair value.

Company's often obtain such valuations for the following reasons:

. Tax purposes (IRS Section 409(a))

. Preparation for going public (dealing with the "cheap stock" issue)

. Requirement of investors

Notwithstanding the value of an independent valuation for accounting purposes, the majority of companies do not have valuation studies performed. This is often due to cost considerations and/or the perception that such a study is not required. Additionally, there are currently no requirements within U.S. generally accepted accounting principles or generally accepted auditing standards for a private company to obtain an independent valuation of its common stock.

�

Use of Independent Valuation Report

In some cases auditors will strongly recommend the use of a third party valuation. However, they may be limited in the ability to actually require clients to obtain an independent valuation. Management should be aware that its auditors will likely need to weigh the facts and circumstances that surround the issue, including other engagement risks. As a result, an audit report modification may become necessary.

Management and auditors are encouraged to identify material valuation issues early in the audit process to ensure timely resolution of the issue.

AICPA Practice Aid

What should management consider if they decide not to obtain an independent valuation?

. The AICPA has published a Practice Aid, Valuation of Privately-Held Company Equity Securities Issued as Compensation. FAS 123R describes this guidance as best practice and strongly suggests its use in the valuation of private company securities.

. Some valuation practitioners have labeled this guidance a de facto FASB, although FAS 123R appears to stop short of a mandate for its use.

. The Practice Aid guidance is not easy for individuals without a valuation background to understand and therefore the majority of companies will likely be unable to effectively utilize it without the assistance of a valuation expert.

To be clear - the AICPA guidance referred to above should be considered in all situations where its use is recommended, whether or not a third party is utilized by management.

�

Management Analysis

When is it Necessary

Absent a readily determinable fair value or an independent third party valuation, management should formally document its considerations and conclusion with respect to the fair value of its common stock. The necessity of the analysis and its ultimate depth will depend on the facts and circumstances of each situation. Situations which would generally indicate the need for formal analysis include but are not limited to the following:

. A company that is seriously considering going public at some point in the future (contemporaneously prepared independent valuations may be required as the IPO is approached).

. A company that issues a significant amount of sharebased payment awards.

. A company that grants share-based awards for which the attributed fair value has historically been or is expected to be significant.

Sale of Common Stock

Although there may not be enough transactions in the company's own common stock to conclusively define fair value, such transactions can be very meaningful in the overall determination of fair value.

. Such transactions may be useful as a test of reasonableness by comparing the transactions to the amount management has designated as the fair value of its common stock.

. Explanations should be obtained for significant differences. For example, the Company sells common stock at $5.00 on November 1, 200X but uses $2.50 to value stock-options granted on December 1, 200X.

. The weight of such transactions as evidence of fair value increases if they are consummated with unrelated parties at arms length.

�

Sale of Other Securities

Private companies frequently issue preferred securities. Because of the difficulty of isolating the value attributable to the preferences; it is generally not practical to use the sale of preferred stock to derive a precise value of the common stock without the aid of a valuation specialist.

However, it may be possible to use the sale of preferred securities to gauge the reasonableness of the amount designated as the fair value of the company's common stock.

For example, it has generally been accepted that the old "rule of thumb" approach to determining the value of common stock, typically by setting the value at 1/10^th of the price of the most recent round of preferred stock is not a reasonable approximation of the value of the preferences beyond formation and possibly the first round of VC financing. Instances where management has valued its common stock using the 10X rule (or an even greater multiple) are likely to be challenged by auditors.

Although it is generally not practicable to conclude with a degree of precision on the specific value of the preferences (without a valuation specialist), it is generally true that as a company moves toward a liquidation event for the preferred shareholders (e.g., IPO or sale) the value of the common stock begins to converge on the preferred. Accordingly, understanding where the company is in its life cycle may be helpful with respect to the question of common stock value.

For example, during the formative timeframe, often little more than completion of the business plan as occurred and it very subjective as to whether the common stock should be valued at 10:1, 8:1, 5:1 or some other ratio relative to the company's preferred stock.

However, the majority of these companies create business plans with milestones and expected accomplishments that justify future rounds of preferred stock financing at presumably higher valuations.

As milestones are accomplished and as the business progresses the company is able to secure additional rounds of financing thereby reducing the risk of business failure and presumably also resulting in a decrease in the premium paid to preferred stockholders.

Accordingly, if a 10:1 ratio had previously been used to determine earlier common stock valuation, subsequent valuations would be expected to reflect the progress of the business thereby reducing the ratio previously used.

�

Consideration of Business Objectives, Milestones and Other Factors

Typical factors that may impact the valuation and merit management's consideration include but are not limited to the following (See Appendix for further discussion):

. Milestones achieved by the entity including those related to technology, sales or other operational achievements.

. Current state of the entity's industry and the economy.

. Factors related to its competitive forces.

. Strategic relationships including those with major customers or suppliers.

. Major new investors.

. The current cost structure and financial condition of the company.

. As progress is made in the business, other factors become increasingly important such as the quality, breadth and depth of the management team.

�

Timing of Option Grants

�

Common Stock Value Compared to the Date Share-Based Awards are Granted

One of the common difficulties faced by management and auditors is evaluating the value of the common stock (and its changes) in relationship to date on which share-based awards are actually granted.

For example at December 31, 2007 the company designates the value of its common stock at $10.00 and at December 31, 2008 due to the achievement of significant milestones raises the value to $15.00. Stockbased� awards are granted on July 31, 2008. What is value of the company's common stock at July 31, 2008?

As you might suspect, there is no easy answer to the question. There is however a presumption that management will consider the relative facts and circumstances surrounding the company and its common stock value at the date of grant.

A typical consideration is how value accrues to the common shareholder. If the increase in common stock value in our above example is the result of slow steady progress towards achievement of corporate milestones, there may be an argument that value builds in a linear fashion. However, what if the achievement driving the increase in value is the result of an unexpected breakthrough in the company's technology?

�

Corporate Governance

In circumstances where the only evidence to establish the fair value of the company's common stock is an analysis prepared by management, management should ensure that reasonable corporate governance procedures are followed.

. Management should ensure that the board of directors (or other governance body) is involved in the valuation process and ultimately approves the common stock valuation.

. Ideally, board members are industry experts and seasoned business people well familiar with valuation concepts. Their involvement ensures that a wider range of perspectives is included in the valuation process versus just the view of the executive management team or simply the chief financial officer.

. The ultimate conclusions reached by the board should be documented in the board minutes. However, sometimes� legal counsel will advise otherwise. Documentation in the board minutes is a corporate governance best practice.

. Auditors will likely need to obtain a management representation specific to the fair value of the company's common stock.

�

Independence

The valuation of a private company security can be a complex effort requiring the use of a valuation� expert. The question often arises as to whether CBIZ is able to assist a client or perform the valuation services on behalf of the client. The following guidance outlines the issue in this situation:

. Independence Interpretation 101-3 views valuation services from the perspective of whether the services affect the financial statements.

. Valuation services contemplated to comply with the requirements of FAS 123(R) are considered to affect the financial statements.

. Independence 101-14 addresses how the independence rules apply to alternative practice structures such as MHM and CBIZ.

The following table depicts the Firm's independence policy related to valuation services which require us to comply with Interpretation 101-3.

�

Prior to the performance of non-attest services for an attest client, it is the obligation of the engagement team to ensure that the requirements of Independence Interpretation 101-3 Non-attest Services have been met.

�

Summary

Management and auditors should be mindful of the significance of share-based awards. For companies that issue a significant number of share-based awards and/or that have share based awards with significant value, careful consideration of the fair value of the company's common stock is required.

. Observe the valuation hierarchy

. Readily obtainable fair value (expected to be rare)

. Independent third party valuation

. Analysis prepared by management

. Management's analysis should consider all relevant facts and circumstances, including but not limited to sales of its own securities (both common and preferred), the achievement of business objectives, key milestones and other indicators of value and the timing of share-based award issuance in relationship to common stock valuation.

. Ensure the corporate governance process surrounding the valuation process is adequate

Appendix - Stages of Enterprise Development

�

The stage of operational development of an entity is an important determinant of the value of the entity. An enterprise builds value throughout the various stages of development but rarely is the value built in a linear fashion. Therefore, it is important to recognize that both the stage of development and the achievement of development milestones (or milestone failures) will influence the perception of risk associated with investing in the entity, which ultimately will impact the valuation. The following depict the typical stages of development.

�

Stage 1

Enterprise has no product revenue to date and limited expense history, and typically an incomplete management team with an idea, plan, and possibly some initial product development. Typically, seed capital or firstround financing is provided during this stage by friends and family, angels, or venture capital firms focusing on early-stage enterprises, and the securities issued to those investors are occasionally in the form of common stock but are more commonly in the form of preferred stock.

�

Stage 2

Enterprise has no product revenue but substantive expense history, as product development is under way and business challenges are thought to be understood. Typically, a second or third round of financing occurs during this stage. Typical investors are venture capital firms, which may provide additional management or board of directors expertise. The typical securities issued to those investors are in the form of preferred stock.

�

Stage 3

Enterprise has made significant progress in product development; key development milestones have been met (for example, hiring of a management team); and development is near completion (for example, alpha and beta testing), but generally there is no product revenue. Typically, later rounds of financing occur during this stage. Typical investors are venture capital firms and strategic business partners. The typical securities issued to those investors are in the form of preferred stock.

�

Stage 4

Enterprise has met additional key development milestones (for example, first customer orders, first revenue shipments) and has some product revenue, but is still operating at a loss. Typically, mezzanine rounds of financing occur during this stage. Also, it is frequently in this stage that discussions would start with investment banks for an IPO.1

�

Stage 5

Enterprise has product revenue and has recently achieved breakthrough measures of financial success such as operating profitability or breakeven or positive cash flows. A liquidity event of some sort, such as an IPO or a sale of the enterprise, could occur in this stage. The form of securities issued is typically all common stock, with any outstanding preferred converting to common upon an IPO (and perhaps also upon other liquidity events). 1

�

Stage 6

Enterprise has an established financial history of profitable operations or generation of positive cash flows. An IPO could also occur during this stage. The actual stages during which liquidity events occur or discussions with investment bankers for an IPO take place depend upon several factors. Those factors include, for example, the state of the economy, investor sentiment, and the state of the IPO market.

�

Excepted from AICPA Practice Aid, Valuation of Privately-Held Company Equity Securities Issued as Compensation.

�

December 2008

SuperUser Account — Mon, 01 Dec 2008 20:57:00 GMT

Dec- 2008

The Substance of the Standard

Significant Changes to Business Combination and Noncontrolling Interest Accounting

Contents

Acquisition Method .............2

Acquisition Date .................2

Consideration Paid .............3

Recognition &

Measurement .....................6

Disclosures ....................... 11

Noncontrolling

Interests.............................12

Allocation of Net Income

or Loss...............................13

Changes in

Ownership ........................13

Step Acquisitions ..............14

Summary of Significant

Changes to GAAP.............15

As initially communicated in the December 2007 edition of the MHM Messenger, the Financial Accounting Standards Board (FASB) issued Statements 141(R) on Business Combinations and 160 on Noncontrolling Interests in Consolidated Financial Standards. These statements will significantly change the accounting, as well as the presentation and disclosure for business combinations and noncontrolling (i.e., minority) interests.

Both statements are effective as of the beginning of annual periods beginning on or after December 15, 2008. Early adoption is prohibited. Statement 141(R) will be applied to business combinations for which the acquisition date is during a fiscal year beginning on or after the effective date.

�

Thus, for an entity with a June 30 year end, FAS 141(R) would only apply when the acquisition date is July 1, 2009 or later. Statement 160 will be applied prospectively to all noncontrolling interests, including any that arose before the effective date.

�

There are significant changes to key definitions, the recognition and measurement of assets acquired and liabilities assumed under the new "acquisition method" (formerly the purchase method), as well as presentation and disclosure issues for business combinations and noncontrolling interests. As with FAS 141, FAS 141(R) applies to acquisitions of businesses through asset acquisitions, as well as stock acquisitions.

�

Key Definitions and Scope

Business combination - A transaction or other event in which an acquirer obtains control of one or more businesses.

The new definition expands the applicability of business combination accounting, since control can be obtained through ways other than purchasing equity interests or net assets (i.e., by contract alone, through the lapse of minority veto rights, etc.). See Accounting Research Bulletin (ARB) 51 for further guidance on control.

�

Business - An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants.

�

A set of activities and assets may be considered a business even if it currently does not have customers or is in the early development stage. Business combination accounting applies to all business entities, including mutual entities, except for the following:

. The formation of a joint venture.

. The acquisition of an asset or group of assets that does not constitute a business.

. A combination between entities or businesses under common control.

. A combination between not-for-profit organizations or the acquisition of a for-profit business by a not-for-profit organization.

�

Mutual entity - An entity other than an investorowned entity that provides dividends, lower costs, or other economic benefits directly to its owners, members, or participants. Mutual insurance companies, credit unions and cooperative entities are all considered mutual entities.

�

The Acquisition Method

One significant change is that the acquisition method is much more fair value focused than the previous "purchase method". FAS 141(R) uses the FAS 157 definition of fair value, which is based on a market participant's perspective rather than the acquirer's specific planned use or non-use of the asset. See further discussion on this key concept in the Recognizing and measuring assets, liabilities and noncontrolling interests section.

The acquisition method requires the following to be performed and documented:

. Identify the acquirer.

. Determine the acquisition date.

. Determine the consideration paid for the acquiree (i.e., purchase price).

. Recognize and measure the identifiable assets acquired, liabilities assumed and any noncontrolling interest in the acquiree.

. Recognize and measure goodwill or a gain from a bargain purchase.

�

Identifying the Acquirer

Acquirer - The entity that obtains control over the acquiree. In a business combination in which a variable interest entity is acquired, the primary beneficiary of that entity always is the acquirer.

�

The guidance in ARB 51 should be used to identify the acquirer. If it is still unclear who the acquirer is, the guidance in FAS 141(R) Appendix A, paragraphs A11 - A15 should be used.

�

Determining the Acquisition Date

The determination of the acquisition date is extremely important because it is the date at which items (i.e., assets acquired, liabilities assumed, consideration paid, etc.) are recognized and measured at fair value.

�

Acquisition Date - The date on which the acquirer obtains control over the acquiree.

The date on which the acquirer obtains control of the acquiree generally is the date on which the acquirer legally transfers the consideration, if any, acquires the assets and assumes the liabilities of the acquiree (i.e. the closing date). However, the acquirer might obtain control that is either earlier or later than the closing date.

For example, the acquisition date precedes the closing date if a written agreement provides that the acquirer obtains controls of the acquiree on a date before the closing date. However, the control obtained would need to be in fact and not just for convenience as implied by simply designating an "effective date."

�

Determining the consideration paid for the acquire (i.e., purchase price)

�

One significant change is that acquisition costs (i.e., finder's fees, due diligence costs, certain legal and accounting costs, appraisals, etc.) are excluded when determining the consideration paid under the acquisition method, but were previously included under the "purchase method." Instead, these costs are accounted for under other generally accepted accounting principles (GAAP) and generally will be expensed as incurred, unless they are associated with debt issuance costs or the issuance of equity securities.

When costs are incurred by the acquiree for the benefit of the acquirer, the acquirer should record a pre-acquisition prepaid asset. Post acquisition, the asset would be eliminated and the expense recognized.

�

All consideration paid for the acquiree should be measured at fair value as of the acquisition date. Consideration paid can include cash, other assets, equity interests, member interests in mutual entities, contingent consideration, etc. The assets or liabilities transferred as part of the consideration paid may have carrying amounts that differ from their fair values at the acquisition date. If so, the acquirer shall remeasure the transferred assets or liabilities to their fair values as of the acquisition date and recognize the resulting gains or losses, if any, in earnings. If the acquirer issues equity instruments, as full or partial payment for the acquiree, the fair value of the acquirer's equity instruments will be measured at the acquisition date.

�

If any share-based payment awards are exchanged by the acquirer for awards held by the acquiree's employees, they should be recorded as a liability or equity in accordance with FAS 123R Share-Based Payments and included in the consideration paid or recognized, in part or in full, as compensation expense. The accounting is dependent on evaluating the awards and segregating them into the following two categories, based on the proportion of the requisite service period and the service required post acquisition:

1. ) Acquisition consideration.

2. ) Post acquisition compensation

However, unlike prior GAAP, the portion of the sharebased payment that is part of the consideration paid is a temporary difference between the tax basis and the reported amount. Therefore, a deferred tax asset should be recognized as part of the acquisition accounting. Statement 141(R) paragraphs 43 - 46 and A91 - A106 provide additional guidance.

�

Contingent consideration - Usually is an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. However, contingent consideration also may give the acquirer the right to the return of previously transferred consideration if specified conditions are met.

Contingent consideration is occasionally used in acquisition transactions and are commonly referred to as "earn-out" provisions. It's used in situations when the price for the acquiree is subjective, due to potential industry conditions, growth projections, emerging technologies and products, lack of historical financial information, etc. Thus, if the company performs as expected post acquisition, the sellers receive additional purchase price. These "earn-out" provisions can include financial or nonfinancial measures or both.

Prior GAAP requires recognizing the cost of the contingent consideration only when it is reasonably assured that the payments will be made to the selling shareholders. Typically this would have been recorded as additional goodwill.

New GAAP may reduce the attractiveness of using contingent consideration in acquisitions, because it requires the contingent consideration to be recorded at fair value as of the acquisition date and there may be significant risks and uncertainty at the acquisition date as to whether any of the contingent consideration will ever be earned or if so, for how much will be paid. In any event, an estimate of the fair value of the contingent consideration arrangement must be made, which factors in the probability of the estimated payments.

�

The acquirer shall classify an obligation to pay any contingent consideration as a liability or as equity in accordance with FAS 150 Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity or other applicable GAAP.

�

If the contingent consideration is a liability, at each subsequent reporting date the fair value is required to be revalued, until the contingency is resolved. Any changes would generally be recorded directly to earnings, unless the arrangement is a hedging instrument or if the changes in fair value are the result of additional information about the facts and circumstances that existed at the acquisition date, that are determined during the measurement period. See the Measurement Period section.

�

Equity settled contingent consideration arrangements do not require any subsequent fair value adjustments and shall be accounted for within equity.

�

The new GAAP with regards to contingent consideration presents challenges, because of the difficulty in determining the fair value of any contingent consideration. The FASB suggests that buyers may look to negotiations with the sellers to assist in quantifying the fair value. However, this will be a complex calculation and will likely require the advice or use of a valuation specialist for the initial measurement, as well as for valuation during any subsequent periods until the contingent consideration is resolved.

�

Any funds held in escrow, as specified by the purchase agreement, may or may not be deemed to be contingent consideration. The underlying reasons and requirements for the escrow funds to be disbursed should be evaluated as to whether they meet the definition of contingent consideration.

�

Example - Contingent Consideration

At Acquisition: Company A acquires 100% of Company B. The acquisition price includes an earn-out provision that may allow Company B's owners collect a total of $3 million over the next 3 years, by earning $1 million each year, if Company B achieves annual budgeted growth. The fair value of the contingent consideration to be paid over the next three years is determined to be $2 million at the acquisition date.

End of Year 1: Company B significantly exceeded budgeted growth and earned the $1 million earn-out and was paid. The fair value of the remaining contingent consideration was revalued at the end of year 1 to be $2 million. As result the following entries were recorded:

�

End of Year 2: Company B barely met budgeted growth and earned the $1 million earn-out and was paid. The fair value of the remaining contingent consideration was revaluated at the end of the year 2 to be $500,000. As a result the following entries were recorded:

�

End of Year 3: Company B did not meet budgeted growth and thus did not earn the $1 million earn-out.

As a result the following entries were recorded:

�

Other Factors Impacting Consideration

�

When part of the combination or transactions of the acquiree are done for the benefit of the acquirer or the combined entity, these actions should be accounted for separately from the business combination, such as for:

. A preexisting relationship or arrangement is settled.

�

For example, the acquirer is being sued by the acquiree for patent infringement. The acquirer eliminates the lawsuit by buying the acquiree. The acquirer would account for the lawsuit separately and record the fair value of contingent liability at the acquisition date with an offsetting charge to P&L and allocate a part of the consideration paid to the settlement of the liability

�

For example, the acquirer has a long-term contract to buy materials from the acquiree. The contract price is unfavorable compared to the current market price available to the acquirer and there is no settlement provision in the contract. The acquirer eliminates the unfavorable contract by buying the acquiree. The acquirer would accountfor the settlement of the purchase contract separately and record a loss for the difference between the unfavorable contract and market as of the acquisition date and allocate part of the consideration paid to the settlement of the liability. If the contract provided for a settlement amount, the loss recorded separately would be the lesser of the settlement amount or market adjustment.

. Compensation for future services is provided.

�

Contingent consideration arrangements that require the receiver to provide services to the post acquisition entity are usually compensation arrangements rather than consideration paid.

�

For example, the acquiree revises the CEO's employment contract to provide for a change-incontrol payment while negotiating to be acquired. The payment is made by the acquiree before the acquisition date. This is probably a postcombination severance payment rather than an acquiree expense. The acquirer would record a prepayment asset during the acquisition. The post acquisition entity would record a severance expense and eliminate the prepayment asset.

�

For every transaction related to a business combination, the following factors should always be evaluated:

a. The reason for the transaction

b. Who initiated the transaction

c. The timing of the transaction

�

This evaluation is needed to determine which transactions should be accounted for separate from the consideration transferred.

�

Recognizing and Measuring Assets, Liabilities and Noncontrolling Interests

Fair Value - The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

�

As indicated earlier, one significant change is that FAS 141(R) uses the FAS 157 definition of fair value for measurement, which is based on the market participant's perspective rather than the acquirer's specific planned use or non-use of the asset. The asset's highest or best use would be used when measuring its fair value, regardless of the acquirer's plans for the asset.

�

For example, the acquirer purchases the acquire because the acquiree's technology competes with the acquirer's product. The acquirer decides not to sell the technology or use it internally. The acquirer should record an asset for the technology at its market price fair value; regardless of whether the acquirer's use. Subsequent to the acquisition date, the asset should not be written down, unless it is deemed impaired under FAS 142.

�

Under prior GAAP (i.e., the "purchase method") the cost of the consideration paid was accumulated and allocated to the individual assets acquired and liabilities assumed based on their estimated fair values.

�

While, the acquisition date is the date at which the assets acquired, liabilities assumed and any noncontrolling interests are recognized and measured at fair value, some limited exceptions to the recognition, fair value measurement or both, exist for specific types of identifiable assets and liabilities. For these exceptions, the acquirer shall apply specified existing GAAP. The following is a list of some of these specific types of exceptions:

. Assets held for sale - The acquired long-lived assets (or disposal group) classified as held for sale in accordance with FAS 144 Accounting for the Impairment or Disposal of Long-Lived Assets, shall be measured at fair value less cost to sell as of the acquisition date, in accordance with paragraphs 34 and 35 of that Statement.

. Employee benefits - The liability should be recognized and measured in accordance with existing applicable GAAP (i.e., FAS 43, 106, 112, 158, etc.)

�

FAS141(R) retains the significant guidance in FAS 141 on recognizing any intangible assets acquired, separately from goodwill, with only minor changes. This includes the continuation of the concepts of "contractual or other legal rights" and "separability" in determining what intangibles should be recognized.

�

Contractual or other legal rights - Arises from contractual or other legal rights regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.

Separable - Capable of being separated or divided from the entity and sold, transferred licensed, rented, or exchanged, either individually or together with a related contract, identifiable asset, or liability, regardless of whether the entity intends to do so.

�

To qualify, the assets and liabilities must meet the definition of such under FASB Concepts Statement 6.

In addition, they must be solely part of the exchange for the business combination. In certain cases the asset or liability may not have been previously recognized by the acquiree. FAS 141(R) also points out that there can be identifiable intangible assets associated with other assets being recorded.

For example, operating leases of a lessor may also give rise to a customer list and/or customer relationship that should be recorded as an intangible asset.

�

The acquirer shall classify or designate the identified assets and liabilities assumed in accordance with acquirer's operating and accounting policies and the contractual terms, economic conditions and other pertinent conditions as they existed at the acquisition date. However, two exceptions apply:

1.) Lease contracts - operating or capital.

2.) Contracts written by insurance enterprises.

For these items, the acquirer shall classify those contracts based on the contractual terms and other factors at the contract's inception date in accordance with FAS 13 or FAS 60. For instance, if the acquiree classified a lease as an operating lease, that classification/designation would be retained by the acquirer and would not need to be reevaluated. This is a recognition principle and should not be confused with measurement of the fair value as of the acquisition date.

�

However, if the terms of the contract have been modified due to the acquisition in a manner that would change its classification, the modification date should be used in the determination.

�

FAS 141(R)'s measurement principles present challenges because of the difficulty in determining "fair value." These will inevitably result in complex calculations and will require advice or use of a valuation specialist.

The changes in the recognition principles, as well as the requirements for fair value measurement, will significantly change accounting practices for the following acquired items:

. Contingencies

. Income taxes

. Indemnification assets

. In-process research and development (IPR&D)

. Reacquired rights

. Restructuring costs

Contingencies in business combination accounting are more likely to exist with respect to liabilities assumed than assets because the conditions for recognition of a contingent asset generally are not met at the date of acquisition. Under the new GAAP, contingencies are bifurcated into two categories, with the accounting being different for each.

�

1. ) Contractual contingencies are recognized at fair value at the acquisition date and may result from any of the following, but are not limited to:

. Licensing and royalty agreements

. Lease agreements

. Service agreements

. Warranty agreements

. Employment contracts

�

2. ) Noncontractual contingencies are recognized at fair value at the acquisition date if it is "more-likelythan- not" that the contingency meets the accounting definition of an asset or liability. Morelikely- than-not is defined to mean greater than 50 percent likelihood of occurrence. An example of a noncontractual contingency is a lawsuit.

The measurement of a contingency post acquisition depends on whether the contingency is an asset or a liability.

Contingent assets are measured at the lower of:

a. Acquisition date fair value

b. Best estimate of the future settlement amount.

Contingent liabilities are measured at the higher of:

a. Acquisition date fair value

b. Amount that would be recognized if measured

under FAS 5.

Changes in the measurement of the contingency post acquisition would be recorded directly to earnings.

Contingent liabilities can be increased subsequent to the acquisition, but cannot be decreased until settlement. A noncontractual contingency that did not qualify for the "more-likely-than-not" recognition at the acquisition date, could in fact be recognized and measured post acquisition if it met the FAS 5 requirements.

�

The new GAAP will put greater pressure to identify potential contingencies in due diligence, since the post acquisition measurement adjustment would impact earnings. Contractual contingences that existed at the acquisition date that are not identified until after the initial accounting may represent an error and, depending on the magnitude and materiality, may require restatement of previously issued financial statements. As a result, more detailed procedures may be necessary by acquirers to identify material contingencies.

On October 29, 2008, the FASB added a project to its technical agenda to reconsider the guidance in FAS 141(R) related to contingencies. The Board authorized the staff to draft a proposed FASB Staff Position (FSP) revising the initial recognition and measurement of assets and liabilities arising from contingencies to a model similar to the one in FAS 141. The FSP is currently expected to retain the subsequent measurement and accounting guidance in FAS 141(R) with additional clarification to address derecognition and require disclosure of the measurement attribute applied; and, if not measured at fair value, the reason that fair value could not be reasonably estimated. This Substance of the Standard will be updated by a MHM Messenger upon completion of this FASB project.

�

Income taxes with regards to the acquirer's unrecognized tax benefits (i.e., net operating losses) that are recognizable as a result of the acquisition are not to be included in the acquisition accounting, as required by prior GAAP. Instead, the amounts should be recognized in income tax expense.

�

Adjustments for recognized tax benefits related to the acquiree (i.e., adjustments to a valuation allowance) that are recognized subsequent to the acquisition date, generally will be recognized in income, not as an adjustment to the acquisition accounting, as required by prior GAAP.

�

Indemnification assets are assets the acquirer obtains if the seller has contractually indemnified the acquirer for the outcome of a contingency or uncertainty related to all or a part of a specific asset or liability.

The acquirer recognizes an asset at the same time it recognizes the indemnified item, which shall be measured initially and subsequently on the same basis as the indemnified item, subject to the need for a valuation allowance for non-collectibility. The acquirer derecognizes an indemnification asset only when it collects the asset, sells it or otherwise loses the right� to it.

For example, the seller has guaranteed that the acquirer's liability will not exceed $100,000 for an environmental liability (noncontractual contingency). At initial measurement, the fair value of the contingency is deemed to be $500,000. The acquirer would recognize an asset for $400,000 at the same time it recognizes the liability for $500,000.

�

In-process research and development (IPR&D) projects of the acquiree are measured at fair value and recognized as an asset rather than expensed on the acquisition date as required by prior GAAP. The asset is treated as an indefinite-lived intangible asset as of the acquisition date. Post acquisition, the intangible asset is subject to impairment testing and fully expensed if abandoned. Upon completion of the project, the asset will be amortized. However, post acquisition research and development costs will continue to be expensed as incurred in accordance with FAS 2.

�

Reacquired rights may exist when an acquire obtained the right to use an asset of the acquirer, prior to the business combination (i.e., franchise right, technology licensing agreement, etc.). In addition to the acquirer recording a settlement gain or loss outside of recording the business combination (see the Other Factors Impacting Consideration section), the acquirer also records an intangible asset for the reacquired right as part of the business combination.

The reacquired right is measured based on the remaining contractual terms of the contract giving the acquiree the right. Potential contractual or noncontractual renewals that a market participant would consider in estimating the rights are excluded. The intangible asset for the reacquired right is amortized over the remaining contract period for the right or is used in determining the gain or loss if the reacquired right is subsequently sold to another party.

�

Restructuring costs under FAS141(R) that are associated with restructuring or exit activities, but that do not meet the recognition criteria in FAS 146 as of the acquisition date, are required to be subsequently

recognized as post acquisition expenses once the recognition criteria is met.

�

Other Measurement Considerations

Allowances for loan losses or bad debts relating to receivables are not carried forward. Instead, the receivables are recorded at the acquisition date fair value, which factors in both current interest rates and credit quality.

Operating leases already in force almost certainly contain terms that are different from the terms that would be available in the marketplace as of the acquisition date, which would result in an asset or liability being recorded in conjunction with the assumption of this obligation.

�

If the acquiree is the lessor in the operating lease, the acquirer recognizes an asset if the existing lease terms are favorable to the acquiree/lessor.

For example, assume a lease has a remaining lease term of 4 years and the market rate for such a lease is lower than the rate in the existing lease. The acquirer would record an asset for the favorable lease and amortize it over the remaining lease term.

In addition, the acquirer would recognize the asset for the property subject to the operating lease as of the acquisition date fair value, without regard to the effect of the lease contract.

If the acquiree is the lessee in the operating lease, the acquirer recognizes a liability if the existing lease terms are unfavorable to the lessee/acquiree or an asset if the existing lease terms are favorable, each of which is amortized over the remaining lease term.

Thus, an asset (if favorable) or liability (if unfavorable) would be amortized over the remaining lease term as a credit or debit to lease expense, respectively.

�

Capital leases of the acquiree, irrespective of whether the acquiree is the lessor or lessee, result in the acquirer recognizing the various assets and any related liabilities assumed at their acquisition date fair values

Noncontrolling Interests

All noncontrolling interests should be reflected at fair value as of the acquisition date. The fair value of the noncontrolling interest could very likely be different, on a per share basis, compared to the parent company holding the controlling interest. This is because of a control premium and/or a non-control discount

As is the case with determining fair values of the assets acquired, determining the fair value of any noncontrolling interests as of the acquisition date could result in complex calculations and require advice or use of a valuation specialist.

�

Parent - An entity that has a controlling financial interest in one or more subsidiaries (also an entity that is the primary beneficiary of a variable interest entity).

�

Subsidiary - An entity, including an unincorporated entity such as a partnership or trust, in which another entity, known as the parent holds a controlling financial interest (also a variable interest entity that is consolidated by a primary beneficiary).

�

Only a financial instrument issued by the subsidiary that is classified as equity in the subsidiary's financial statements can be a noncontrolling interest. Additionally, it may be possible that all of the subsidiary's equity is noncontrolling interest if the parent company controls it by other means and consolidates the entity (i.e., contract, nonequity VIE under FIN 46R). See the Accounting and

Presentation of Noncontrolling Interests section for further information on noncontrolling interests Recognizing and Measuring Goodwill or a Gain from a Bargain Purchase

�

Goodwill - An asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized.

�

Goodwill is the excess of the consideration paid over the recognized net assets acquired and liabilities assumed in a 100% acquisition of the acquiree.

Assume Company A acquires 100% of Company B, as an asset purchase, for $10 million in cash, plus additional consideration if certain requirements are met in the next year. The fair value of the contingent consideration at the acquisition date is determined to be $1.5 million. The fair value of the net assets acquired and liabilities assumed, including a contractual contingency, are valued at $8.5 million at the acquisition date.

Example 1- 100% of the business acquired

When less than 100% of an acquiree is acquired, but control is obtained, the noncontrolling interest is taken into account during the calculation of goodwill. The accounting for this partial acquisition under FAS 141(R) is substantially different than prior GAAP.

Goodwill is instead allocated to the controlling and noncontrolling interests. The amount of goodwill allocated to the controlling interest is the difference between the fair value of the controlling interest and the controlling interest's share in the fair value of the recognized net assets acquired.

Example 2 - 60% of the Business Acquired

Assume the same facts as in Example 1, except that Company A paid $8 million in cash for a 60% interest, which includes a control premium, and the fair value of the remaining 40% noncontrolling interest is valued at $2,000,000.

�

Bargain purchases occur when the recognized net assets acquired exceed the fair value of the consideration paid plus the fair value of any noncontrolling interest.

�

Before recognizing a gain, the acquirer should reassess whether it has identified all of the assets acquired and liabilities assumed and should then review the procedures used to measure the amounts recognized. This reassessment should be documented.

If no adjustments are necessary, or if an excess remains after the adjustments, the acquirer should recognize the excess as a gain at the acquisition date A bargain purchase should be rare. The reasons for a bargain purchase (i.e., forced sale, acquiree wanting to quickly sell the business for health or other personal reasons, etc.) should be understood and documented. In addition, the reasons are required to be disclosed in the financial statements. Under prior GAAP, the reported amounts of the long lived assets are reduced to zero before any remaining amount is recognized as an extraordinary gain.

Measurement Period

Because of the timing of an acquisition in relation to a financial statement reporting date and/or limitation of the acquirer's access to the acquiree, the acquirer may need to record provisional amounts for the business combination. Like FAS 141, FAS 141(R) allows for a certain period of time to make any necessary adjustments to the provisional amounts during the measurement period.

�

Measurement period - The period after the acquisition date during which the acquirer may make adjustments to the "provisional" amounts recognized at the acquisition date.

�

The measurement period ends as soon as the acquirer receives the necessary information about facts and circumstances that existed at the acquisition date or concludes that the information cannot be obtained. However, this period may not exceed one year from the acquisition date. Any adjustments to the provisional amounts shall be made retrospectively by restating the prior period information.

Judgment is necessary to determine what information obtained during the measurement period indicates the existence of an asset or liability as of the acquisition date and the amount to be recorded as of that date.

�

Disclosures

The required disclosures for FAS 141(R) and 160 are voluminous and focus on transparency in the financial statements. Some of the more significant disclosure requirements are as follows:

. Information about the acquired receivables by major classes, including:

a. Fair value of the acquired receivables.

b. Gross contractual amount of the receivables.

c. Best estimate at the acquisition date of the contractual cash flows that are NOT expected to be collected.

. Information about the assets/liabilities arising from acquired contingencies, including:

�

a. Amounts recognized or an explanation of why no amount was recognized.

b. The nature of the recognized and unrecognized contingencies.

c. An estimate of the range of outcomes (undiscounted) of recognized or unrecognized contingencies or why a range cannot be provided.

�

. Periods subsequent to the acquisition,

information about changes to provisional amounts, contingent consideration and assets and liabilities for recognized contingencies.

. Information on transactions recognized separately, including:

�

a. Description of the transaction.

b. How each transaction was accounted for.

c. The amounts and line item for each transaction.

d. If the transaction is a "settlement" amount, how it was determined.

�

. How the amounts and where acquisition costs are accounted for.

. Bargain purchase gain amount and line item and why the transaction was a bargain purchase.

. The amount and how the fair value of noncontrolling interest was determined.

. The fair value and any gain or loss recognized (and line item) to adjust a previously owned� investment in the acquiree.

. Public companies - The impact of the acquisition on the consolidated financial statements, including:

a. Revenue and earnings included subsequent to the acquisition

b. Various supplemental pro forma information

Accounting and Presentation of Noncontrolling Interests

FAS 160 requires noncontrolling interests to be treated as a separate component of equity, not as a liability or other item outside equity, and should be clearly identified and labeled (i.e., noncontrolling interest in subsidiaries).

Because noncontrolling interests are an element of equity, increases and decreases in the parent's ownership interest that leave control intact are accounted for as capital transactions rather than as step acquisitions or dilution gains or losses. Thus, any subsequent acquisitions of ownership or reductions in ownership by the parent will be accounted for in the equity section, assuming the parent retains control (i.e., does not result in deconsolidation).

�

For these types of noncontrol changes in ownership, the carrying amount of the noncontrolling interests is adjusted to reflect the change in ownership interests, and any difference between the amount by which the noncontrolling interests are adjusted and the fair value of the consideration paid or received is recognized directly in equity attributable to the noncontrolling interest (i.e., additional paid-in capital).

�

Example 3 - Control Retained

Assume the same facts in Example 2 and that one year later Company A purchases an additional 20% of Company B (half of the outstanding noncontrolling interest) for $600,000. Company B's net income and comprehensive income during the year was zero. Since Company A had control both before and after the transaction, the transaction is recorded as an equity transaction. The noncontrolling interest is reduced by the carrying amount of the proportionate interest relinquished ($2,000,000 x 20% / 40%).

The difference between the carrying amount of the noncontrolling interests acquired ($1,000,000) and the amount paid ($600,000) is reported as an adjustment to paid-in capital. The entries would be as follows:

�

DR Noncontrolling Interest $1,000,000

CR Additional paid in Capital $ 400,000

CR Cash $ 600,000

Allocation of Net Income or Loss

Net income or loss and comprehensive income or loss, shall be attributed to the parent AND the noncontrolling interest. Thus, there should no longer be a charge or credit in the income statement to arrive at net income for the portion attributed to the noncontrolling interest. Examples from the Consolidated Statement of Income are as follows:

�

Under prior GAAP this portion of equity was usually reported outside the consolidated entity's equity section and the amounts of earnings and comprehensive income attributable to minority interest were treated as a charge or credit to arrive at the consolidated entity's net income or comprehensive income.

One significant change from FAS 160 is that the noncontrolling interest shall continue to be attributed its share of losses even if the attribution results in a deficit noncontrolling interest balance in the equity section.

Changes in Ownership

A gain or loss is only reported in earnings if the parent ceases to control the subsidiary (i.e., deconsolidates the subsidiary) as a result of a single transaction, or as a result of a series of transactions that are to be considered a single transaction. The gain or loss is calculated as follows:

�

Any retained investment in the former subsidiary is recorded by the former parent at its deconsolidation date fair value. Thus, the gain or loss recognized in income includes the realized gain or loss related to the portion of the ownership interest sold AND the gain or loss on the remeasurement to fair value of the interest retained. In subsequent periods, the retained investment is accounted for under the other applicable GAAP for such investments, such as APB 18.

�

Example 4 - Loss of Control

Assume the same facts in Example 3 and that one year later, Company A sells 55% of its interest in Company B, leaving Company A with a 25% interest. Thus, a change in control occurred. The 55% interest in Company B is sold for $5,000,000. Company B's net income and comprehensive income for the year is zero. The fair value of the 25% retained interest in Company B is determined to be $1,500,000. The carrying amount of Company B's net assets is $11,500,000 ($8,500,000 net assets + $3,000,000 goodwill). Company A would recognize a loss on the date of the sale computed as follows:

�

Step Acquisitions

Unplanned step acquisitions may result in a business combination being achieved in stages. Under FAS 141(R), the acquirer's interest in the acquire includes the acquisition date fair value of the equity interest the acquirer held in the acquiree before control is obtained. Therefore, the carrying amounts of the previously acquired tranches are adjusted to fair value as of the date control is obtained (i.e., acquisition date). Also, the acquirer recognizes the differences as a gain or loss in income at the acquisition date.

Amounts the acquirer previously recognized in accumulated other comprehensive income (i.e., cumulative translation adjustments recognized during the period the equity method was used to account for the investment tranches) would be included in the gain or loss recognized in income at the date control is obtained.

�

Under prior GAAP, each investment tranche is reflected in the financial statements at its cost either through the application of the equity method or in consolidation once control is obtained.

�

Planned series of transactions are addressed in FAS 160, to prevent manipulation of income through a series of planned acquisitions designed to take advantage of the remeasurement event through earnings when obtaining or surrendering control. The statement identifies the following four conditions, one or more of which may indicate that multiple arrangements should be accounted for as a single transaction:

. The arrangements are entered into at the same time or in contemplation of one another.

. They form a single transaction designed to achieve an overall commercial effect.

. The occurrence of one arrangement depends on the occurrence of at least one other arrangement.

. One arrangement considered on its own is not economically justified, but the arrangements are economically justified when considered together.

Summary of Significant Changes - Prior GAAP vs. New GAAP

The Substance of the Standard is a publication of the Professional Standards Group of Mayer Hoffman McCann P.C. This publication is designed to provide accurate information in regard to the subject matter covered. It is provided with the understanding that it does not constitute legal, accounting or other professional advice. Please contact your MHM service provider for more information.